A Big Change for Natural Gas?

After almost a year of inquiry and sometimes rancorous debate in government and the natural gas industry, the Federal Energy Regulatory Commission (FERC) on October 9, 1985, promulgated a new rule that may change considerably the industry's structure and performance. The rule is designed to promote more competitive and smoothly functioning gas markets, including more "open access" to interstate pipeline transportation services for gas sellers and buyers.

Further changes may be in the offing: Order 436, as the new rule is known officially, encompasses only part of the broad initiative announced by the FERC in its Notice of Proposed Rulemaking issued May 30, 1985. Among these potential regulatory changes is a "block-billing" proposal that seeks to rectify market distortions that result from continued field price regulation of "old" gas. The block-billing proposal has been especially controversial, and all of these issues will cause continued wrangling in the months ahead.

History and background

For fifteen years after the Supreme Court's 1954 Phillips decision, which extended federal regulation of natural gas pipeline companies to cover field prices of gas dedicated to interstate commerce, natural gas markets, like energy markets generally, exhibited great stability. Demand growth was easily met by expansions of supply, and prices remained essentially flat. During the 1970s, however, shortages in the interstate market began to occur as additions to reserves, constrained by price controls, failed to keep pace with rising demand stimulated both by economic growth and by oil-price increases. The situation came to a head in 1976 and 1977, when various conditions, including extremely severe weather, resulted in widespread curtailments of supplies.

The shortages prompted Congress to pass the 1978 Natural Gas Policy Act (NGPA), which provided for the gradual, partial decontrol of wellhead prices. The act stipulated perpetual regulation of prices for "old" gas supplies (generally those developed prior to the NGPA) below market levels, but immediate decontrol of "high-cost" gas (including gas found at great depths) and deregulation of substantial volumes of "new" gas (developed after the NGPA) by January 1, 1985. As expected, the relaxation of price controls stimulated new supplies that, along with a softening of gas demand, eliminated chronic shortages.

Unfortunately, the NGPA fell short of a full cure, and at least three broad problems now afflict industry members, end-users, and regulators:

• On average, gas prices rest above a market equilibrium level. As a result, perhaps 10 percent to 15 percent of gas supplies could be sold and delivered but are not—an obvious source of social waste.
• Efforts to cope with excess supply have not always resulted in price declines or reduced use of highest-cost gas. Instead, in many cases lower-cost supplies have been shut-in while willing buyers and sellers have been unable to consummate transactions for them because of limited access to transportation facilities. Thus, current patterns of production and consumption do not minimize social cost.
• Regional disparities occur in burner-tip gas prices other than those attributable to delivery costs. These disparities also reflect economic inefficiency because, in a more smoothly functioning market, gas would flow from higher-cost to lower-cost regions until prices (net of transport costs) were equalized—to the benefit of all concerned.

These broad problems arise largely from the collision of a market driven increasingly by competitive forces with established market and regulatory institutions that often are not suited to the new environment. For example, regional price disparities stem both from continued field price regulation of old gas, which gives pipelines different volumes of these cheap supplies, and from public utility price regulation that calls for average-cost pricing by pipelines and local distribution companies rather than marginal-cost pricing. Problems of sticky prices in the face of excess supply, and inefficient patterns of production and consumption, come at least partly from provisions in long-term contracts that limit price adjustments and impose greater minimum-purchase requirements on high-cost gas than on low-cost gas in the field.

The situation has been aggravated further by other regulatory provisions such as FERC certification requirements on pipelines, which restrict initiation and abandonment of service, and by structural conditions in the gas market, including territorial-restriction clauses in downstream contracts. Both impediments limit competitive adjustments to market conditions. Finally, many argue that the private-carrier status of interstate gas pipeline companies, which gives them discretion over access to "bottleneck" transmission facilities by independent shippers, is a further obstacle to enhancing market efficiency. Of course, pipeline owners vigorously dispute this assertion.

The industry itself has tried to alleviate these problems. Field contracts have been revised to be more flexible. To reduce their "take-or-pay" obligations under minimum purchase requirements, pipe-lines established "special marketing programs" for selling gas at competitive prices to industrial users. (Special marketing programs were introduced by producers and brokers as well.) However, a federal appeals court, ruled that these programs could not continue because they did not provide equal access to distribution companies or other high-priority, "captive" customers; the programs terminated on November 1, 1985. Transportation of customer-owned gas by pipelines also has increased.

Nevertheless, many regulators and other observers agree that industry-initiated actions are not sufficient to the task and that more fundamental changes through regulatory reform or legislative action, or both, are required. A smaller number agree on the need for a comprehensive effort that addresses the problems simultaneously, rather than focusing on one while ignoring—or even aggravating—others. Such an effort would include broadening access to transportation facilities and related measures to enhance the competitiveness and efficiency of the gas market; reducing distortions resulting from the combination of rolled-in pricing with uneven endowments of old gas; and some altering of existing contract requirements to conform with current market realities. As indicated below, the FERC plan laid out in the Notice of Proposed Rulemaking attempts such a comprehensive overhaul, but its ultimate success remains to be seen.

The FERC initiative

FERC's Order 436, intended to broaden access to pipeline transportation facilities, also contains a limited initiative to foster contract renegotiation. The block-billing proposal to reduce distortions from price controls on old gas was sufficiently controversial that it was not included in the order; instead, additional comments were requested with a target of early 1986 for further FERC action. The details of the order and the proposal are both complex and important, but for illustrative purposes, the FERC initiative can be summarized in fairly simple terms.

Under Order 436, interstate gas pipelines remain free to continue the traditional practice of purchasing gas in the field for resale to downstream customers, thus bundling gas sales (and storage) with transportation services. (The prevailing view was that FERC lacked statutory authority to compel changes in pipeline practices.) But if a pipeline wishes to continue transporting gas owned by others, it either must agree to do so on a nondiscriminatory basis or request authorization for offering transportation on a case-by-base basis, with typical lags of six to eighteen months per case. Pipeline rates for transportation would continue under FERC regulation and would allow for customer payments to reserve pipeline capacity. If a pipeline elected to become a nondiscriminatory "contract carrier," its sales-plus-transportation contract customers would have the option of converting to transportation-only arrangements by gradually reducing contract gas demand over several years, beginning in 1986. (Industrial transportation-only customers would be able to continue these transactions as soon as FERC approved the pipeline transportation certificate.)

FERC also initially proposed a stipulation whereby pipelines would be able to include charges in their rates that reflect lump-sum payments to producers for settling accrued take-or-pay liabilities, as an inducement to promoting renegotiations of contracts in the field. However, Order 436 simply provides for producers to receive expedited authorization of release from obligations to provide pipelines with gas reserves and delivery capability, should the parties wish to have the gas released as part of a contract revision.

To put it mildly, FERC's order was greeted with less than universal enthusiasm. While producers, and particularly independents, generally support the the intent of the rule, they are concerned that it lacks sufficient teeth to compel pipelines to provide more open access. Pipelines by and large bitterly oppose the rule, arguing that it exposes them to grave risks of load instability and load loss (as customers convert to transportation-only service and force pipelines to compete for volumes), while providing insufficient relief from, and negotiating leverage to cope with, take-or-pay liabilities and other contractual problems. Many distributors and their state regulators worry about the loss of traditional supplies if pipelines increasingly specialize in providing transportation, thus forcing distributors to assume more of the merchandising function and risks in the market and raising questions about cost and reliability of supplies. Finally, consumer groups object to the delay in providing distributors access to transportation and opportunities to purchase lower-cost supplies.

The controversial block-billing proposal calls for pipeline rates for gas sales that segregate price-controlled old gas from new gas, with old gas dedicated to existing long-term customers (most of whom are distribution companies) based on historical purchase volumes. By preventing average-cost pricing of pipeline gas sales, the plan seeks to level the playing field among pipelines with differing endowments of old gas and to increase efficiency by promoting pricing of incremental production, sales, and consumption volumes (by existing customers, by new customers in existing territories, or in new market areas) at marginal cost. Such a change would reduce the marketability of very high-cost gas, which currently is being sustained by cushions of regulated gas.

Pipelines' perspectives on the proposal depend, in part, on whether they have large or small endowments of price-controlled gas, since those with smaller cushions would gain if marginal purchase costs in the field fall. But pipelines as a group are concerned that the proposal would tighten the squeeze between declining sales prices for incremental volumes and rigid price requirements in contracts for high-cost gas. On the other hand, many producers fear that the plan would cause field prices for new gas to tumble toward their current level in the competitive spot market for short-term sales—near or even below the marginal cost of replacing gas reserves. However, this argument overlooks the supply glut concentrated in this narrow segment of the market; with broader access to transportation and thus greater market flexibility, new contract prices likely would be above current spot levels.

From a broader perspective, how distributors and state public utility regulators respond to block-billing will bear importantly on both the desirability and political feasibility of the proposal. To the extent that distributors continue to practice rolled-in pricing, the potential benefits of the plan will be blunted in the market areas they serve; indeed, in some cases efficiency could be reduced to the extent that distributors can undercut pipeline competitors who could serve industrial customers directly at lower cost. Conceivably, block-billing also could increase distributor incentives to practice monopoly price discrimination—setting rates for residential and commercial customers above the cost of service, capitalizing on low elasticities of demand—in the absence of more stringent local regulation. Finally, some observers argue that the plan goes too far in leveling the field, in that dedication of old gas to existing customer bases reduces the scope of interpipeline competition.

Outlook

Most students of the gas industry agree that broader access to pipeline transportation facilities is desirable, both for the majority of industry participants and for society as a whole. However, the structural changes envisioned by Order 436 have been very slow to materialize; as of December 1985, only a small number of pipelines had agreed to provide nondiscriminatory transportation, and most of these had done so for only a brief interim period provided for in the rule. As a consequence, spot gas transactions and transportation for third parties essentially ground to a halt, which raised prices as purchasers were forced to substitute long-term system supplies.

Nevertheless, it seems likely that a transition toward a more open-access system ultimately will occur. The existing confusion and hesitancy to act could wane as the new rule is clarified. Refusal to participate in the new system could also expose pipelines to risks of antitrust litigation. Producers' resistance to renegotiating contracts also seems likely to soften more as the alternative arises of bankrupting some pipelines in the absence of increased transportation. Finally, it is possible (but by no means certain) that Congress could opt to impose more open access and to address both the "contracts problem" and price controls on old gas.

The outlook on block-billing is even murkier in view of the political controversy over the plan, the volume of substantive debate over its merits, and the addition of three new FERC commissioners since Order 436 was promulgated. A legislative alternative—deregulation of old gas prices—has been available for a number of years, but its implementation remains at best problematic. With this legislative gridlock and with serious doubts about FERC's legal authority to alter price ceilings without new legislation, the debate about natural gas pricing may persist for some time.